Debtor was the original payee of a $50,000 promissory note executed by Smith, payable to Debtor. To secure its $30,000 line of credit from ABC Finance Co. (ABC), Debtor signed a security agreement granting ABC a security interest in the Smith note; Debtor then endorsed the Smith note and delivered possession of it to ABC. Under the agreement, ABC was to maintain possession of the Smith note and was to enforce its rights in the note only if Debtor defaulted.

One month later, ABC obtained a $1,000,000 line of credit from Bain Capital (Bain). ABC signed a security agreement with Bain, which grants a security interest in all of ABC’s payment rights from its customers (including accounts, instruments, and chattel paper). As part of this security agreement, Bain required ABC to pledge the Smith note, which ABC did by endorsing the note and delivering it to Bain. [Bain did not know that ABC only held a security interest in the Smith note.]

Three months later, Debtor paid off the balance due to ABC on its line of credit, terminated the line of credit, and demanded that ABC return the Smith note. Which statement is correct?

1. Because Debtor has now paid off the debt secured by the Smith note, Debtor has redeemed the note and Bain must return the note to Debtor.

2. Debtor has a cause of action against ABC, but Bain took its interest in the Smith note free of Debtor's ownership rights in the note.

3. Bain must return the note to Debtor; Bain’s interest is invalid because ABC violated its security agreement with Debtor by purporting to grant Bain a security interest in the Smith note.